Kronston Ltd. is a Canadian-controlled private corporation that imports irrigation equipment from Taiwan for distribution in southwestern Ontario. Last year, the company achieved a profit of $600,000 after tax.
Kronston is interested in expanding its operations to the Okanagan region of British Columbia. It recognizes that to be successful, it will require a committed manager who is familiar with the area and understands the special problems of irrigation in that region.
The Okanagan region is capable of generating profits of $250,000 annually. Sonia Harapiuk lives in Vernon, B.C., and has been active in the irrigation business for many years. She is interested in managing the Okanagan expansion, provided that she can have an equity interest in the venture. Kronston is not averse to this, as Harapiuk has proven expertise in the industry and her equity participation would ensure a long-term commitment.
She has requested 50% equity in the venture and has sufficient funds to provide her share of the capital required to start the venture. Kronston had been thinking of allowing Harapiuk to purchase a 25% interest in the Okanagan activity. The company feels that her participation is important but also sees other alternatives. Before making a decision, the president of Kronston has asked his financial manager to determine the financial cost of allowing Harapiuk to own 50% instead of 25% of the new venture. The project will require a total capital investment by the owners of $800,000. Kronston has other opportunities for investing its funds, and these opportunities can yield pre-tax returns of 25% annually.
Required:
What would be the financial cost to Kronston of permitting Harapiuk to have the equity interest in the new venture that she has requested? Assume corporate tax rates are 15% on income subject to the small-business deduction and 25% on other business income.